The Contract for Difference (CFD) trading is a highly leveraged and complex process which is ideally suited to very experienced traders and investors. Although CFDs can be very lucrative and provide an opportunity to make a lot of money at a faster pace, the trader might end up losing a lot of money just as quickly if traded hastily. Even with a small initial investment, there is potential for very high returns. A major drawback is that the margin trades can not only magnify profits but losses as well. The luring advantages of CFD trading often disguise the associated risks.
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There are the following types of risks:
1. Counterparty Risk
This type of risk is based on the probability that one of the parties involved in a transaction might default on its contractual obligation. There is a chance that either the financial institution which is giving CFD opportunities or the individual(s) seeking it will be unable to make the required payments on their debt obligations. Both the lenders and investors are exposed to this risk as any of them can fail to fulfil their financial obligations. Since both of the parties are equally in a risky position, therefore both should consider strict evaluation before finalizing the contract.
2. Market Risk
Market risk is a type of risk which is prevalent in CFD trading. There is a huge possibility that an investor experiences losses due to various factors that affect the overall performance of the financial market in which he/she is involved. It is also called systematic risk. It could be due to a recession, unexpected information, political turmoil, changes in interest rates or government policies, natural disasters and terrorist attacks. These factors can have an unfavorable effect on the value of the financial instrument. Losses due to market risks can happen to the most educated and experienced trader/ investor.
3. Liquidity Risk
Liquidity is the ability of an individual, firm or a company’s ability to cover its debts and obligations without suffering catastrophic losses. Therefore, liquidity risk arises due to the lack of marketability of an investment that can’t be bought or sold quickly enough to prevent or minimize a loss. Market conditions affect many financial instruments, any negative news and it would increase the risk of losses. Due to the fast-moving nature of financial markets, the price of a CFD can fall even before a trade can be executed.
4. Client Money Risk
In most countries, there are client money protection laws to protect the investor/trader from potentially harmful practices of CFD providers/brokers. However, the law may not prohibit a client from pooling his/her money into one or more accounts. This can happen when a contract is agreed upon. The trader/investor has to submit some amount into the account, and the broker has the right to draft from the pooled account with potential to affect returns. This can be really risky without confirming the reputation of both ends.
No investment can generate profits without putting money at risk. However, there are few ways to mitigate those risks, if used wisely. A trader/investor can use stop-loss orders or Guaranteed Stop Loss Order. But before investing in CFD, it is important to assess the risks associated with leveraged products. The resulting losses can often be greater than initially expected profits.
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